OCIE Issues Guidance for Strengthening the Municipal Underwriting Due Diligence Process

April 02, 2012

On March 19, 2012, the U.S. Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Examination Risk Alert (“Alert”) regarding the need for improved due diligence practices in municipal underwritings. The Alert was issued on the heels of recent MSRB rule proposals and guidance on retail municipal underwritings1 as well as the expansion of municipal underwriters’ obligations as a result of 2010 amendments to Rule 15c2-12. The Alert addresses broker-dealers’ compliance obligations in municipal underwritings as well as the risks to investors of those offerings. The Alert summarizes some of the Commission’s National Examination Program (“NEP”) concerns with respect to municipal underwritings, and the NEP’s ongoing compliance examinations of broker-dealer municipal securities underwriting activities.

Underwriter Due DiligenceThe Alert explains the due diligence obligations of broker-dealers when underwriting a municipal securities offering and notes that by participating in an offering, the firm makes an implied recommendation about the securities it is underwriting.

Securities Exchange Act Rule 15c2-12 (Municipal Securities Disclosure) sets forth the obligations of a broker-dealer when underwriting municipal securities. In addition to the rule, the SEC has issued guidance in this area requiring broker-dealers to engage in a “reasonable basis” determination or “due diligence” with respect to initial offerings of municipal securities.2 A firm that does not comply with the due diligence requirements may be found to have violated Rule 15c2-12, certain MSRB rules, as well as the antifraud provisions of the securities laws.

The Alert reminds broker-dealers of prior SEC guidance regarding due diligence obligations, emphasizing:

  • Under the antifraud provisions, underwriters must review any issuer’s or obligated person’s disclosures made with respect to an offering and must take reasonable steps to reach a conclusion that those disclosures are accurate and complete.
  • Underwriters should evaluate closely the likelihood that an issuer or obligated person will comply on a timely basis with its disclosure undertakings.
  • Underwriters should gather information “reasonably sufficient” to determine if an issuer or obligated person actually has provided the annual filings and event notices as required in its disclosure undertakings. This might include, for example, a review of information available in EMMA.

Supervisory Obligations The Alert reminds broker-dealers of their supervisory obligations in municipal underwritings, including the obligation to have in place methods for ensuring compliance with applicable rules and regulations.

MSRB Rule G-27 (Supervision) sets forth the supervisory obligations of a municipal broker-dealer, including the requirement to have a reasonably designed supervisory system, procedures to implement the system, a process for inspections and a supervisory control system to monitor compliance. The Alert reminds broker-dealers that compliance with Rule G-27 should include compliance with Rule 15c2-12. The Alert further explains that the SEC, under Exchange Act Section 15(b), may sanction a broker-dealer or individual supervisor who “fails to reasonably supervise” a person subject to their supervision who violates the securities laws. The affirmative defense to failure to supervise liability available under Section 15(b)(4)(E) requires a showing that procedures are in place and could reasonably be expected to identify and prevent violations of the securities laws. Merely establishing policies and procedures is not enough to meet supervisory obligations. Appropriate, documented efforts to implement those procedures and a process for following up on any irregularities also are required.

Purpose and Observations of ExaminationThe Alert explains what the examination staff looks for when examining a municipal underwriter’s compliance policies and procedures.

In examining broker-dealers with respect to municipal underwriting activity, NEP staff looks for evidence that a broker-dealer has:

  • An adequate supervisory system and written supervisory policies and procedures identifying due diligence obligations of those persons responsible for compliance with Rule 15c2-12; and
  • Adequate written evidence of the broker-dealer’s performance of its obligations under relevant rules (e.g., Rule 15c2-12; MSRB rules; and antifraud provisions of the securities laws) to enable the firm’s own internal reviews of compliance, as well as SEC examinations.

In this context, the Alert emphasizes that firms should maintain written evidence of their compliance with their due diligence obligations, including in a municipal underwriting context. The Alert notes that the lack of written due diligence records may make it difficult for a firm to evidence compliance with its due diligence obligations, as well as its supervision of such activity.3

Separate from the documentation of due diligence, the Alert reiterates six non-exclusive factors the SEC has indicated are relevant in considering whether an underwriter has a reasonable belief in the truthfulness of key representations in a final official statement. Those factors are:

  • The extent to which the underwriter relied on municipal officials and other persons whose duties have given them knowledge of particular facts;
  • The role of the underwriter (e.g., manager vs. selling group member);
  • Type of bonds being offered (e.g., general obligation vs. private purpose);
  • Familiarity of the underwriter with the issuer;
  • Length of time until the securities mature; and
  • Whether the bonds are competitively bid or are distributed in a negotiated offering.

Staff Examples of Municipal Securities Due Diligence Practices, Policies and ProceduresThe Alert sets forth examples of practices observed by NEP staff that serve to evidence due diligence and supervisory reviews. The examples are not exhaustive, and the Alert indicates that broker-dealers may choose other practices or implement other controls to meet their obligations under the securities laws.

Firms might consider the following in order to meet the obligations with respect to due diligence and supervisory reviews:

  • Implementation of detailed policies and procedures addressing due diligence requirements under Rule 15c2-12, SEC guidance and internal parameters on how personnel can develop and evidence a reasonable basis for offering any new issue municipal security
  • Use of a commitment committee to review and approve underwritings, including municipal securities underwritings. A commitment committee may be asked to review a specific set of material regarding a particular deal (e.g., a due diligence memorandum, portions of the “deemed final” statement). Such committees generally are in addition to the line-of-business supervisory reviews that may be undertaken
  • Use of a due diligence checklist to help create a record of due diligence steps undertaken, including the review of the final or “deemed final” statement and results of an independent review of information repositories such as EMMA.
  • Preparation of due diligence memoranda to describe due diligence efforts undertaken, issues that arose and how they were resolved, and review of the final or “deemed final” official statement
  • Use of outlines during due diligence calls to evidence items discussed, issues and resolutions thereto.
  • Participation in onsite examination activities by firm personnel
  • Maintenance of recordkeeping checklists to help evidence due diligence

The Alert reminds broker-dealers engaged in municipal underwritings of the need — in order to meet due diligence and supervisory obligations — to have in place effective policies and procedures, as well as a supervisory system to detect and prevent violations of the securities laws. The Alert suggests methods a firm can use to support its implied representation that it has formed a reasonable belief about the truthfulness and completeness of the information provided by the municipal issuer in its offering documents. The Alert also provides suggestions on how a firm can document its municipal underwriting due diligence and supervisory efforts.


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1  See MSRB Notice 2012-13 (March 15, 2012);

2  Exchange Act Release No. 33741 (March 9, 1994) (59 FR 12748 (March 17, 1994)).

3  The Alert indicates that some firms told the NEP staff that they did not retain evidence of their due diligence efforts on advice of counsel — advice that the staff clearly questions.

This article was originally published by Bingham McCutchen LLP.